This ETF strategy covers you in stormy markets

Commentary: When stocks are volatile, covered calls offer shelter

By

HowardAtkinson

Getty Images

Traders work on the floor of the New York Stock Exchange.

Should stock investors be cautious come November? The Standard & Poor’s 500 Index has had a strong run since last year, which some analysts believe could make it more susceptible to a pullback. Historically, however, November heralds the beginning of a seasonally strong period for stocks that carries through until April.

Ben Jacobsen and Cherry Zhang of Massey University examined more than 300 years of data from 108 stock markets to see if there is any truth in the old adage to sell in May, or as Don Vialoux puts it, to “Buy when it snows; sell when it goes.” They found that market returns from November through April were on average 4.52% higher than those between May and October. The effect seems to be increasing over time, with the average difference rising to 6.25% over the past 50 years.

The U.S. stock market tells a similar story. Average monthly returns of the S&P 500
SPX, -0.23%
between 1950 and 2013 show that the November to April months have tended to fare better than other months.

Seasonal trends can be explained by many factors, such as fluctuations in consumer demand, inventory lows, weather effects, tax-loss selling, corporate earnings announcements, among others.

With concerns lingering about the U.S. economic recovery and the possibility that the Fed will start to taper its bond purchasing program, how much more can U.S. stocks run before entering a period of heightened volatility? Is now a good time to be out of the market?

For many investors, those are not relevant questions. Exiting a core equity position simply isn’t an option.

Bull market in ‘sixth inning’

(3:41)

Barron's Top 100 Advisor Shelley Bergman is still upbeat on U.S. stocks, but he also sees opportunities in muni bonds, preferred shares, and emerging markets.

For those who want to maintain exposure to the S&P 500 between November and April but worry that the index could advance only moderately, move sideways, or experience increased volatility, a covered call strategy using exchange-traded funds could be considered.

Covered calls are designed to generate additional income from a stock portfolio. Additional income may help mitigate price declines to the extent of the premiums collected. In other words, covered calls can allow you to stay invested in the market, but may provide some protection against heightened volatility.

A covered call strategy involves holding stocks and selling or “writing” call options on them to earn a premium. The option buyer gains the right, but not the obligation, to purchase the stock at a specified price, known as the “strike” price, on or before the option expiry date. If the stock rises above the strike price, the call option will likely be exercised and the option writer will forego any potential returns above the strike price.

Option premiums tend to increase with market volatility. Historically, when the market declines, is range-bound or experiences modest appreciation with greater volatility, covered call strategies have generally tended to outperform their underlying securities.

Self-directed covered call strategies can be complex and time-consuming. ETFs have made them more easily available to retail investors, offering the benefits of professional options management and institutional options pricing at a relatively low cost compared to a self-directed strategy.

There are a few exchange traded products on the market that offer a covered call strategy based on the S&P 500. They write call options on the index as a whole “at-the-money” or at a strike price that is equal to the underlying index level when the options are written. At-the-money options typically command a higher premium than options written “out-of-the-money” or above the index level.

The trade-off, however, is that at-the-money strategies sell away all the upside potential of the index and can therefore drastically underperform in bull markets. The out-of-the-money approach, meanwhile, aims to generate additional income and may preserve some of the monthly upside potential of the S&P 500.

Covered call strategies are one way for investors to maintain a core equity position in the S&P 500 while potentially taking advantage of any heightened volatility in the stocks of the underlying index. While the strategy does not protect from large price declines, it can potentially generate additional income to offset declines.

Accordingly, investors who buy a covered call strategy when it snows may benefit from its structure when it goes.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information. Intraday data
delayed per exchange requirements. S&P/Dow Jones Indices (SM) from Dow Jones & Company, Inc.
All quotes are in local exchange time. Real time last sale data provided by NASDAQ. More
information on NASDAQ traded symbols and their current financial status. Intraday
data delayed 15 minutes for Nasdaq, and 20 minutes for other exchanges. S&P/Dow Jones Indices (SM)
from Dow Jones & Company, Inc. SEHK intraday data is provided by SIX Financial Information and is
at least 60-minutes delayed. All quotes are in local exchange time.